Friday, February 20, 2009

"N" Word Strikes Fear on Wall Street

There are few words that inflame passions on Wall Street like the "N" word. In fact, the word "nationalization" strikes fear at the heart of Wall Street "capitalistas" who will gladly accept government bailouts in the form of TARP, TALF or BARF, but don't you dare utter the "N" word in polite company on Wall Street. That's pure blasphemy!

Speculation about possible bank nationalization by the U.S. government is driving down shares in the sector Friday. However, there's plenty of uncertainty of what nationalization would actually look like.

Nationalization gives the U.S. government the power to control banks. That power could mean anything from taking control of the public shares to replacing existing management, installing a new board of directors and setting corporate strategy. But the lack of clarity surrounding nationalization has created confusion on what's the best path the federal government should take.

"One of the problems in talking about nationalization is there is very little consensus on what the word means," Yves Smith, author of the popular "naked capitalism" blog, wrote in a recent post. "I strongly suspect that the advocates and opponents may have a lot more common ground than they realize."

There are several questions that need to be addressed before nationalization can seriously be considered, said Michael Shedlock, an investment adviser for Sitka Pacific Capital Management. They include what happens to the government guarantees of bank debt and whether both stockholders and preferred shareholders will be wiped out in a nationalization scenario.

"Unless and until those questions are answered, we cannot know to what extent taxpayers are at risk," Shedlock wrote on his blog.

The fear and uncertainty about what comes next for the banks has sent shares of Citigroup and Bank of America down to 52-week lows. Shares of Citigroup recently recovered were down 20% at $2.01, while Bank of America shares have fallen 10% to $3.52.

Citigroup and Bank of America have downplayed the likelihood or need for nationalization and the White House gave assurances that it prefers banks to remain out of the government's hands.

"This administration continues to strongly believe that the privately held banking system is the correct way to go," White House spokesman Robert Gibbs said Friday.

Proponents of nationalization say the government would take control of the largest banks on a short-term basis in order to loosen lending and act as an implied guarantee to soothe customer concerns. But opponents note that nationalized banks might have an unfair advantage over banks that aren't under government control.

Harvard economist Greg Mankiw said if some banks are actually insolvent, then the government should intervene with a "massive reorganization."

"Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure," he recently wrote on his blog, noting the equity holders would get wiped out and bond holders would get the assets. "Suddenly, these financial organizations have a lot more equity capital and not a shred of debt. And all done without a penny of taxpayer money."

On Friday, the American Bankers Association stepped in to defend the large banks against the rising nationalization chatter.

"We would very much like to put an end to the conversation," said Diane Casey- Landry, chief operating officer of the ABA. "One of the challenges is defining exactly what people mean by nationalization. I'm not so sure everybody's talking about the same thing."

Standard & Poor's financial equity analyst Stuart Plesser also expressed concern that Citigroup and Bank of America shares are falling even though there's a lack of clarity surrounding nationalization.

"I'm interpreting that when people are talking about nationalization they are talking about the government taking full control and wiping out equity holders," Plesser said.

He added that it's unlikely the government would take over Citigroup and Bank of America rather than just giving them additional capital if they needed it. "I don't know what they get other than now having to run a bank," he said.

A possible scenario in which nationalization may make sense is if large institutional depositors cause a run on the banks by withdrawing their deposits, Plesser said. A depositor run is what ultimately pushed Wachovia into the arms of Wells Fargo & Co. (WFC), despite Wachovia having strong tier-one capital ratios at the time, he added.

The action on Citigroup (C) and Bank of America (BAC) was ferocious today. Both stocks recovered after-hours, but who knows what will happen next week.

From a technical perspective, this market is way oversold. A friend of mine who is now putting together an option trading fund told me tonight that he went long today because the volume on both the Dow and the S&P was close to the November lows.

Another portfolio manager called me in the afternoon to tell me "don't you believe for one second that they will nationalize these banks. This is all media nonsense".

Yet another buddy of mine who is a CFO of an infrastructure project sent me this comment:

"Nationalization is dumb because it destroys the basic fabric upon which the banking system is built (i.e. Tier 1 capital etc. ...).

Banks need capital in order to function and take risk. The capital is meant to provide a cushion against bad loans. You could argue that the crisis in the United States originates from banks who were taking excessive risk beyond what their capital structure could support.

On the surface, everything appeared normal because this risk was being securitized and sold to investors. The situation was exacerbated when asset values started to fall and the security backstopping these loans was put into question.

If the U.S. Banks are nationalized, nobody will ever return and invest in the banking sector. People are not stupid. My own personal positions in Washington Mutual and Bank of America have been wiped out. It will be long time (if ever) before the U.S. Banking Sector sees a another dime from me. I vam now trying to save what is left of my position in Bank of America.

I think that the same would apply to more prolific investors who were burned over the last 18 months. A few names that come to mind Prince Alwaleed ($1-2B in January 2008), The Abu Dhabi Investment Authority ($7.5B in November 2007),and China Development Bank (2.5B in February 2008).

Therefore, if the U.S. Government decides to nationalize the Banking system, they better be prepared to do so on their own account and at infinitude. Over the last 18 months, they managed to thoroughly screw all the same equity holders that supported the banking system throughout this difficult period. What kind of message does that give investors? Stay away and don't come back!

The new in thing among the cool kids in the world of finance is to do what they did in Sweden. Let's nationalize the banks! Backing this idea are current and former Fed Chairs, Ben Bernanke and Alan Greenspan, the doomster Nouriel Roubini, and Simon Johnson, a former IMF economist who teaches at MIT.

They could be wrong in recommending that we nationalize the banks, and fear that it might happen is driving down banks stocks -- Citigroup (C) fell 20% and Bank of America (BAC) has fallen 14%. But their comments raise some basic questions: What does 'nationalizing the banks' mean? Will it happen in the U.S.? And who would be the winners and losers?

Nationalization of banks means that the government takes them over from private investors. This wipes out common shareholders and replaces the CEOs and management teams with government employees. Sweden nationalized its banks and some cite its success as a reason to do the same in the U.S.

In the early 1990s, Sweden's banks were bankrupt. So Sweden took 100% control of them and put the ones with troubled assets into a "bad bank," where they were held and then sold over time when market and economic conditions improved. In the meantime, it used taxpayer money to provide enough capital to allow banks to resume normal lending.

I don't think the U.S. will nationalize the banks. First of all, the politics of the situation will prevent it from happening. The people who got us into this mess -- Greenspan and Bernanke -- are supporting it, which contributes to the idea's political radioactivity.

But the more important reason not to do it is that our sickest banks are already nationalized in every way that matters. The U.S. is their largest shareholder and is likely controlling key decisions -- and it's not working. By working, I mean that lending is not happening and that's because these zombie banks have too much toxic waste.

If the banks were nationalized, the losers would be just about everyone except for the people who have supported the idea. Taxpayers would lose because they would see their prior investment in the banks wiped out. So would common shareholders who have already lost 95% of their investment.

More importantly, borrowers would suffer because of lost opportunity. The U.S. could create far more credit with a more efficient solution. Moreover, although some of the executives running the banks now should be replaced, I am not convinced that a government employee would necessarily make better decisions than an experienced financial executive.

What should we do instead? Remember the twin goals I described: getting credit flowing and cleaning up the problem assets. To solve the first one, it would be much more effective to create new banks. As I posted, if the U.S. used the second $350 billion of TARP to capitalize new banks, at a 9:1 assets/equity ratio, it would create $3.5 trillion in lending capacity to meet demand (more would be available if private investors chipped in).

This is important because the collapse of the securitization market has wiped out $1.9 trillion -- about half of lending capacity -- the money borrowed by businesses and consumers before credit markets collapsed in 2007.

This leads to the second goal -- how to clean up the troubled assets that are freezing up the market for securitized loans? Securitization is taking, say, 4,000 assets (such as mortgages) putting them in a trust and then selling securities based on the cash flows from those 4,000 mortgages. These securities have a very low value because people are scared to buy them since they don't know which of those 4,000 mortgage holders are likely to keep paying and which aren't.

But we could cut out that cancer and solve the problem. As I posted, there is a solution: let the FDIC buy the, say, 15% of those mortgages that aren't paying. This would free up the mortgage-backed securities to trade freely since the remaining 3,400 mortgages in that security I mentioned above would consist of paying mortgages that would have a real value. Banks could then sell those securities or keep them on their books at a high value. And they'd be able to lend out their capital instead of hoarding it. Meanwhile, the FDIC could work with mortgage holders to restructure the loans and keep their houses off the market.

Sweden's banking system in the 1990s was different than ours is now. So applying the same solution that worked there to a different problem won't have the same positive effect.

Unfortunately, many of the proponents of nationalization only have a hammer on their tool belt, so they think that every problem is a nail. What we face here is a new problem and nationalizing the banks won't solve it.

[Note: Read my friend's comment in the comment section at the end of this post on why he thinks Peter Cohan is out to lunch (click on comments to view).]

I don't like the idea of governments running banks, but then again, these dumb bankers in the United States got greedy and they sowed the seeds of their destruction. It's not as if they did a great job running the banks either.

Speaking to a number of those experts Friday, Paul Volcker, a top economic adviser to President Barack Obama, cited not only the lack of understanding of the global financial meltdown but the "shocking" speed with which it had spread across the world.

"One year ago, we would have said things were tough in the United States, but the rest of the world was holding up," Volcker told a conference featuring Nobel laureates, economists and investors at Columbia University in New York. "The rest of the world has not held up."

In fact, the 81-year-old former chairman of the Federal Reserve said, "I don't remember any time, maybe even the Great Depression, when things went down quite so fast."

He noted that industrial production is falling in countries across the globe faster than in the U.S., one result of the decline caused by the breakdown of unbridled financial markets that operated on a global scale.

"It's broken down in the face of almost all expectation and prediction," he noted.

Volcker didn't offer specifics on how long he thinks the recession will last or what will help start a recovery. But he predicted there will be some lasting lessons from the experience.

"I don't believe it will be forgotten ... and we will revert to the kind of financial system we had before the crisis," he said.

While he assured his audience of his confidence that capitalism will survive, Volcker said stronger regulations are needed to protect the world economy from such future shocks.

And he said he is concerned about the amount of power central banks, treasuries and regulatory agencies have acquired while trying to contain the meltdown.

"It is evident in the United States, and not just in the United States, the central bank is taking on a role that is way beyond what a central bank should be taking," he said.

Volcker stressed the importance of international cooperation in creating a new regulatory framework, particularly for major banks that operate across national boundaries -- the reverse of what's happened in recent years.

"The more international agreement we have on where we want to get to, the better off we'll be," Volcker said.

And while major banks should be more tightly controlled and less able to make the sort of risky bets that led to their current debacle, Volcker said there should also be more oversight of some kind for hedge funds, equity funds and the remaining investment banks.

He scoffed at the notion that those entities must be free to innovate -- stating that financial "innovations" like asset backed securities and credit default swaps have brought few benefits. The most important "innovation" in banking for most people in the last 20 or 30 years, he maintained, is the automatic teller machine.

Well put Mr. Volcker. Wall Street bankers may not like the "N" word, but given the shenanigans that have gone on for far too long at the major banks, it might be time to temporarily nationalize them (or place serious oversight on management), clean house, and get back to the 'nuts an bolts' of banking.

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